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January 2012

01/29/2012

We are resuming our weekly entries. Sorry for any inconvenience we caused.

The Occupy Wall Street movement has not expressed clear goals, but it does want higher taxes on the “rich”. President Obama agreed in his State of the Union address, and proposed that the rich-in his case, anyone with an annual income of at least $1 million- pay no less than 30% of their income in federal taxes. Others have proposed to add annual taxes on household wealth, in addition to taxes on income. The fact is that Obama’s tax goal is already being met by the complicated American tax code, while even a small wealth tax would discourage savings and create other problems.

According to a 2010 study by the Congressional Budget Office, the effective federal tax rate on the top 1 percent of households has already been about 30%. This might seem to be a misprint since very wealthy persons like Warren Buffet and Mitt Romney report that they pay only about 15% of their income in taxes. However, much of their incomes come from investments that are first taxed at the corporate tax rate of 35%, and then the after-corporate tax income is taxed again when paid out as corporate dividends, or when capital gains are realized.

According to the same CBO study, federal taxes on the middle classes comprise on average only about 15% of their incomes, This disparity in tax rates indicates that the American tax system is already quite progressive when corporate income taxes are combined with personal income and capital gains taxes. To be sure, it is inefficient to have such high tax rates on corporate incomes. Eliminating the corporate income tax, and then taxing personal incomes, capital gains, and dividends at the same rate would go a long way to both simplifying the tax code and to improving its efficiency.

Better still would be to scrap entirely the income tax, and substitute a consumption (i.e. sales or value added) tax instead (see the more extended discussion of a general consumption tax in my post on 8/29/11). Even if consumption of the poor were taxed at lower rates, the current bloated level of federal spending could be financed with a consumption tax on the great majority of households of no more than 25%. The effective tax rate does not have to be high because a generally flat consumption tax would be far more efficient, in particular, it would be more encouraging to investments, than the present complicated personal and corporate income tax system.

An income tax is an indirect tax on wealth because it lowers the value of the assets that produced the taxable income. Nevertheless, support has recently emerged for a direct tax on wealth to go along with taxes on incomes. Some forms of wealth are already directly taxed, such as property taxes levied by most local governments, and taxes on estates of deceased individuals. Henry George in his book Progress and Poverty (1879) made a famous proposal for a wealth tax in the form of a 100% tax on increases in the value of land. This single tax, he believed, could replace all other taxes. George argued that a land tax was a good tax because, so he claimed erroneously, the value of land did not depend on what landowners did, but rather depended only on forces like population growth that were beyond their control.

Current proposals for a wealth tax go beyond taxes on particular assets, like land or housing, and envisage a much broader tax that includes financial wealth, like stocks and bonds. I only say “broader” since a viable wealth tax would still exclude wealth in the form of human capital, the most important form of capital in modern economies, and the source of wage and salary incomes. Since the richest one percent of households on average get about half their incomes from wages and salaries (the remaining 99% get almost all their income from human capital), much of the true wealth of the rich would escape a wealth tax.

Another major problem with even a small tax rate on wealth is that it implies a very high tax rate on savings. Consider a constant 2 percent tax on wealth, and suppose that a household saves $10,000 out of its income to raise its future wealth. A one year 5% return on these savings would increase its before tax wealth next period by $10,500. Since a 2 % wealth tax on $10,500 would leave an after-tax value of just $10, 290, such a wealth tax would reduce the after-tax return form 5% to only 3%, a 40% reduction.

So what seems like a small tax on wealth of only 2% is the equivalent of an income tax on savings of 40%. Presumably, this would discourage savings and increase consumption, whereas sustained higher long-term growth in GDP requires greater, not lesser, savings. As I mentioned earlier, the discouragement to savings of an income (or wealth) tax is a major reason why consumption taxes are better.

Wealth taxes have several other serious problems in addition to their negative effects on savings. It is almost impossible to value accurately many sources of tangible wealth, such as the value of privately owned businesses, so that an actual wealth tax would be rather narrow. Moreover, forms of wealth that can be most easily valued because they have good asset markets, such as stocks and bonds, can be moved across countries, and hidden through complex arrangements of assets.

Therefore, I conclude that a general tax on wealth is undesirable because it is both inefficient and ineffective. A feasible wealth tax is dominated by consumption taxes, including even progressive consumption taxes, and by inclusive income taxes.

Inequality in income and wealth has grown very substantially in the United States in recent decades, and appears to be at a historical high. That would hardly be noticed, in a society such as ours that is strikingly free of envy, were it not for the last almost three and a half years of economic distress. The distress is not felt by the wealthy; this is noticed, and angers the nonwealthy, who are naturally inclined to think that the distress should be shared, and that increasing the progressivity of the tax system would be a step in that direction, and should be taken. Many people are worried by the nation’s huge public debt, and it is natural to think that raising taxes on the wealthy would reduce that debt by reducing the gap between government revenue and government spending. Furthermore, Federal Reserve and other regulatory officials, who I believe were (with a helping hand from many academic economists) primarily responsible for the economic distress because of unsound interest-rate and regulatory policies, and regulatory laxness, and general cluelessness, have managed to shift the blame, in the mind of the public, for the economic distress to the financial industry. Markets are Darwinian, and the industry’s reliance on short-term capital, both financial and human, compels risk taking to the farthest degree that the government will allow, and the Greenspan-Bernanke Fed and its staff and the entire financial regulatory establishment allowed too much risk taking. But this is not widely understood; the reappointment of Bernanke as Chairman of the Federal Reserve helped to conceal recognition of the point.

But as long as a substantial segment of the public blames the wealthy, the pressure for making the tax system more progressive presents a political as well as an economic issue. An increase in progressivity that does little economic harm would be a low-cost response to the political pressure, though the President’s recent proposal to tax people who earn more than $1 million at a rate that will make them pay 30 percent of their income in federal income tax carries symbolism too far. If a person who earns $1 million a year and is taxed at an effective rate of 25 percent is subjected to such an imposition, instead of paying $250,000 in taxes he will have to pay $300,000, and he will therefore do whatever it takes to reduce his income from $1 million to $999,999, as that will save him $49,999.

Marginal income tax rates can be increased slightly, deductions trimmed slightly, the budget of the Internal Revenue Service increased so that the tax laws are enforced more effectively, and income tax forms simplified, and the result of these modest measures would be a small increase in government revenues at a small—I would guess a negligible—cost in economic growth. Anything more ambitious in the way of tax reform probably is politically infeasible, given our disordered political system, and, more interesting, probably economically infeasible as well. While there are good theoretical arguments for replacing income with consumption taxes, as discussed by Becker, the administrative and transitional costs would be staggering; and so with any effort to overhaul the federal income tax system rather than just tinker at the edges of it.

Grandstand gestures like the proposed millionaire tax would have only the slighest effect in alleviating resentment at the rich, and should be understood as campaign documents rather than serious proposals.

As for a tax on wealth as distinct from income, I agree with Becker that it is an uncommonly silly idea. I would again stress issues of implementation, rather than theoretical objections (for example that the wealth tax would necessarily exclude human capital from taxable wealth, despite its importance). It would be an enormous undertaking to compel everyone in the United States (for one cannot identify who is wealthy by income alone, since one can have great wealth but a small income, depending on the form the wealth takes) to value his entire wealth honestly. Would everyone who owns a home have to submit an appraiser’s evaluation? And who would pick the appraiser?